What are credit rating companies and their impact on the economy

07/07/201105/30/2014 by Editorial Team

At the outset, credit rating estimates the credit worthiness of either an individual, corporation, or even a country. The credit rating is usually a company, referred to as a credit rating agency which assigns the credit ratings for the issuers, which is a legal entity that develops, registers and sells securities for the purpose of financing its operations.

This legal entity, as mentioned earlier can be an individual, corporation or a country which issues debt securities such as bonds in order to raise money.

1916: First credit ratings on corporate bonds and sovereign debt

Credit rating plays an important role as it estimates if the subject (individual, corporation or a country) has the potential to pay back the loan. This can be a critical factor especially from a lender or investor’s perspective. As obvious, a poor credit rating indicates a high risk of the subject defaulting on the loan and vice versa. Credit ratings play an important role in setting the interest rates on the loan or money that is required to be raised.

A sovereign credit ratings is the credit ratings of a sovereign enterprise, i. e. a new national government. The sovereign credit rating indicates the level of risk of the investing environment of a country and can be utilized by investors aiming to invest abroad. The sovereign credit rating also considers the political risk factor as well. Whenever a new business or federal government issuer engages a credit rating agency to supply a credit score on a future debt concern, the company generally assigns the rating towards the issuer, called a good Issuer Credit score (ICR), which displays an entity’s general capacity to satisfy its obligations prior to their conditions. The company then assigns ratings towards the issuer’s particular debt investments.

Factors that influence credit ratings or a credit score

Credit rating score is drawn upon the information from the subject’s credit report. While there are many various factors that play a role in the credit rating score, what’s important to notice is that the factors that impact one subject’s credit rating score can be entirely different to the factors that impact another subject’s credit rating score. This is due to the differences in the individual subject’s credit reports.

Credit rating does not provide guidance on other aspects that are essential for investment decisions, aspects such as market liquidity or price volatility are ignored. This is why, for example, from a country’s perspective, bonds with the same rating may have different market prices.

Credit rating agencies

Of the many credit rating agencies, the ones that matter on a global scalre are:

Countries can issue government bonds denoted in the country’s currency in order to raise capital. Bonds can also be issued in foreign currency, referred to as soverign bonds. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain period of time, with an interest rate, to a country. Bonds are often referred to as risk free due to the fact that they are government owned and hence, governments can at any time raise taxes or create extra currency in order to redeem their bonds upon maturity. However, as we have seen recently, the issue of Greece counters this statement.

Bonds are rated on various parameters such as:

Economic Resiliency

the country’s economic strength, captured in particular by the GDP per capita – the single best indicator of economic robustness and, in turn, shock-absorption capacity.

institutional strength of the country, the key question being whether or not the quality of a country’s institutional framework and governance – such as the respect of property right, transparency, the efficiency and predictability of government action, the degree of consensus on the key goals of political action – is conducive to the respect of contracts.

Combining these two indicators helps determine the degree of resiliency, and position the country in the rating scale: very high, high, moderate, low or very low.

Financial Robustness

the financial strength of the government. The question is to determine what must be repaid (and how “tolerable” the debt is) and the ability of the government to mobilize resources: raise taxes, cut spending, sell assets, obtain foreign currency.

the susceptibility to event risk – that is the risk of a direct and immediate threat to debt repayment, and, for countries higher in the rating scale, the risk of a sudden multi-notch downgrade. The issue is to determine whether the debt situation may be (further) endangered by the occurrence of adverse economic, financial or political events.

Combining these two indicators helps determine degrees of financial robustness and refine the positioning of the country on the rating scale.

Determining the rating

The determination of the exact rating is done on the basis of a peer comparison, and weighting additional factors that may not have been adequately captured earlier.

Fitch Ratings developed a rating system in 1924 that was adopted by Standard & Poor’s

Credit scores are aimed at reducing information asymmetries by giving information on all the rated security. Credit ratings also help answer some principal-agent trouble, such as capping how much risk an investor can take on the part of the principal. Besides, ratings can answer collective action trouble of dispersed arrears investors by helping the property to monitor performance, with downgrades serving in the form of signal to do this.

Key facts about credit ratings

Credit ratings are only opinions about the relative credit risk of the subject

Credit ratings are not investment advice, or buy, hold, or sell recommendations. They are just one factor investors ‘might consider’ in making investment decisions

Credit ratings are not indications of the market liquidity of a debt security or its price
in the secondary market.

Credit ratings are not guarantees of credit quality or of future credit risk

Issues plaguaing the credit rating agencies

Moody’s Corp and Standard and Poor’s triggered the worst financial crisis in decades when they were forced to downgrade the inflated ratings they slapped on complex mortgage-backed securities, a U.S. congressional report concluded. In one of the most stark condemnations of the credit rating agencies, a Senate investigations panel said the agencies continued to give top ratings to mortgage-backed securities months after the housing market started to collapse.

And in more recent news, Moody’s came under sharp criticism from the European commission following the downgrading of Portugal’s debt status to junk. The commission claims that Moody’s are guilty of making assumptions that Portugal might need a second bail-out based on their credit rating.

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